The small business corporation (commonly referred to as the S
corporation) is a form of business ownership that may provide
substantial income tax benefits to its shareholders. If properly
planned, the income tax benefits generated from this form of business
ownership can be substantial.

First, the taxable income of the S corporation is taxed directly to
its shareholders according to their pro rata share of ownership in the
corporation. As a result, the corporate entity avoids payment of
corporate income tax. Instead, the income is reported directly by the
shareholders on their individual income tax returns, as are losses of
the S corporation which are reported directly by the shareholders on
their individual return. In this way, the double taxation normally
accorded the income of a regular C corporation is avoided. If the
individual shareholder is in a lower tax bracket than the corporation,
an overall income tax saving is achieved.

Second, when a shareholder dies and the estate becomes the owner of
the S corporation stock, the passive loss rules may apply. If the estate
has substantial passive income, the losses from any passive activities
of the S corporation may be used to offset the passive income, achieving
a reduction or elimination of income tax liability for the estate.

Third, if a shareholder dies and the estate owns the S corporation
stock, the estate will receive a stepped-up basis on the value of the
stock. This step-up in basis may be sufficient enough, from a tax
perspective, to permit a deduction of losses that the decedent could not
have deducted if the step-up in basis had not occurred. This is
especially true when the amount of the deductions exceeds the
decedent's basis in the stock.

If these tax benefits are to remain viable for the shareholders of
the S corporation, as well as for the beneficiaries of estates
containing S corporation stock, proper lifetime planning is imperative.
Without it, the corporation could inadvertently lose its S corporation
status and the tax benefits associated with this form of ownership. This
article focuses on planning strategies that may be used for a transfer
of S corporation stock from a shareholder or a shareholder's
estate.

Pitfalls to Avoid

A corporation does not become an S corporation without proper
planning. An election must be made by the shareholders to treat their
corporation as an S corporation for income tax purposes. To be
considered for S corporation treatment, the business entity must meet a
number of Internal Revenue Code eligibility requirements. Code Section
1361 requirements prohibit a business entity from becoming an S
corporation if the corporation:

1. Has more than 35

shareholders; 2. Has a nonresident alien or a

nonhuman entity (such as a

partnership) as shareholder

(Certain kinds of trusts, as

explained later, are excluded

from this nonhuman entity

category.); and 3. Has more than one class of

stock.

If a corporation possesses any of these characteristics, it cannot
elect S corporation treatment. Proper planning, therefore, becomes
imperative to ensure that none of these situations occurs.

Well-meaning stockholders who wish to benefit their beneficiaries
and younger family members through transfers of S corporation stock may
be unaware that they are jeopardizing the corporation's eligibility
to qualify as an S corporation. The following kinds of transactions most
frequently result in disqualification for S corporation treatment:

1. Transfers to disqualified shareholders under Code Section 1361
(b) (1) (B). This would include both lifetime gifts and testamentary
transfers of S stock to an ineligible corporation, a partnership, a
nonresident alien or any kind of trust that is not exempted under the
qualification rules. (Only Section 678 trusts, certain grantor trusts,
certain testamentary trusts and trusts that meet the definition of a
qualified sub-chapter S trust are permitted to hold S corporation
stock.)

2. Transfers to spouses who subsequently obtain a divorce. Under
the Code provisions relating to the grantor trust rules, a husband and
wife are considered a single shareholder for purposes of S corporation
eligibility. Thus, if transfer of stock is made to a husband and wife
who hold the stock jointly as the 35th shareholder, a subsequent divorce
and property settlement splitting the S stock equally would result in
the two being considered separate shareholders. As a result, there would
now be 36 shareholders instead of 35, and the corporation, in the
absence of planning, would lose its S corporation status.

3. Transfers that result in more than 35 shareholders. Other types
of transfers can result in the disqualification of a corporation for S
corporation treatment. For example, if a shareholder makes a bequest of
his S corporation stock in equal shares to his three children, this
transfer results in two additional shareholders for eligibility
purposes. Similarly, if each of these children dies, survived by two
children each, three more shareholders have been added, bringing the
total to five over what it was when the original shareholder died. Under
these circumstances, it is very easy to see how the 35 limit can easily
be exceeded, resulting in a disqualification for S corporation
treatment.

4. Transfers of stock pending a lengthy estate administration.
Under Reg. 1.64 (b)-(3) (a), if the estate of an S corporation
shareholder is unduly long, the estate could be terminated for tax
purposes and each beneficiary of the stock under the shareholder's
estate plan would be considered an individual shareholder. Thus, it
would be relatively easy for the number of shareholders to exceed the 35
limit, disqualifying the corporation.

Planning Strategies

To ensure proper retention of S corporation eligibility for a
shareholder, the corporation and its intended beneficiaries, the
following strategies should be considered:

1. Where feasible, all members of the S corporation should enter
into shareholders' agreements that restrict or prohibit transfers
of stock to disqualified shareholders, such as partnerships, nonresident
aliens and trusts that do not fall within the exceptions of Code Section
1361. Also, the language of the agreement should ensure that each
shareholder's interest in the stock must be a fee simple interest.
Interests in the stock for a term of years or for a life estate would
disqualify the stock for S corporation treatment under Prop. Reg.
1.1361-1A (f)(3). Finally, any agreements entered into should specify
that there is, and can be only one class of stock for the corporation.

2. Where feasible, the stockholders should enter into a restrictive
agreement that prohibits a transfer of shares where such a transfer
would result in more than 35 shareholders. Normally, a cross purchase
agreement entered into among the current shareholders (and funded
appropriately with life insurance or accumulated earnings) could be used
to accomplish this purpose. However, before pursuing such an agreement,
local law should be consulted to ensure that such restrictive agreements
are enforceable, especially in light of a surviving spouse's
elective share statute or other statutory authority that gives the
surviving spouse the right to select the S corporation stock from the
decedent's estate. Such statutes could effectively override the
provisions of such a restrictive agreement that might otherwise prevent
the number of shareholders from exceeding 35. Another solution might be
to have the spouse become a party to the agreement and, under its terms,
expressly waive his or her rights to select the property under the
elective share statute.

3. In a situation involving a lengthy estate administration, the
administrator of the estate should attempt to qualify the estate for
installment payments of federal estate tax under Code Section 6166. If
the estate meets the eligibility requirements (basically, the value of
the stock must exceed 35% of the decedent's adjusted gross estate),
it may be possible to extend the payment of federal estate taxes out
over a 14-year period, thus ensuring that the estate will remain open
for tax purposes. In this way, the estate cannot be terminated, and the
stock will be able to retain its eligibility as S corporation stock.

4. When a shareholder plans on transfers of S corporation stock for
the benefit of family members, every attempt should be made to qualify
the transfer of the stock under one of the trust arrangements recognized
as valid transfer devices for S corporation stock.

Specifically, the shareholder should consider the use of a
qualified subchapter S trust (QSST) or a Section 678 trust. Either trust
permits the stock to be held in trust while still qualifying for S
corporation treatment.

Code Section 1361 defines a QSST as one which:

1. Owns stock in one or more

electing S corporations; 2. Distributes, or is required to

distribute, all of its income to

one individual or resident of

the United States annually; 3. Has certain trust terms,

especially requiring that there be

one trust beneficiary at any

given time; 4. Does not distribute any

portion of the corpus to anyone

other than the current income

beneficiary during the income

beneficiary's lifetime; and 5. Ends the income interest of

the current beneficiary upon

his death or the termination of

the trust, whichever occurs first.

Of course, to be treated as a QSST, the trust beneficiary must make
an election by signing and filing a statement at the IRS center where
the S corporation files its income tax return. In addition, the executor of the

shareholder's estate needs to make the appropriate election on
the decedent's federal estate tax return, which qualifies the
property for marital deduction treatment.

With careful drafting, it is possible to qualify a QSST as a Q-TIP
trust for the primary benefit of the shareholder's surviving
spouse. Upon the death of the surviving spouse, S corporation
eligibility could be retained by creating a separate QSST for each
remainderman of the Q-TIP trust, assuming that these remaindermen are
the children of the decedent and the surviving spouse, and also assuming
that the creation of such separate QSSTs would not result in more than
35 shareholders in the corporation.

It might also be possible to qualify a marital (general power of
appointment) trust as a Section 678 trust, thus preserving the S
corporation status, as well. The Section 678 trust is any trust that
treats the trust beneficiary as the owner of the entire trust corpus if
the beneficiary has the sole power to vest either the income or the
corpus in himself in the form of a general power of appointment. A
marital trust that gives the surviving spouse a general power of
appointment in either the income or the corpus, or both, could qualify
for the marital deduction in the estate of the decedent and also could
retain its status as S corporation stock, provided that the
decedent's estate followed all procedures for qualifying the
property for the marital deduction.

Because the Section 678 trust gives the beneficiary a general power
of appointment over the trust corpus or income, such a trust would
probably be inappropriate where the shareholder wished to make transfers
of S corporation stock to a minor child. A transfer to a UGMA or UTMA account on behalf of the child would be more appropriate.

Conclusion

By following the strategies outlined in this article, it is
possible to preserve the income tax benefits of the S corporation while
transferring the stock to family members or other intended beneficiaries
as a part of the shareholder's estate plan.

Paul J. Lochrary, JD, is an academic associate at the College for
Financial Planning, Denver, Colorado, where he develops course materials
for the Estate Planning Series of the Advanced Studies Program.

COPYRIGHT 1990 National Society of Public Accountants
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